Chapter 11, Problem 2PSA

Most Company has as opportunity to invest in one of two new projects. Project Y requires a $350,000

Investment for new machinery with a four-year life and no salvage value. Projects Z requires a $350,000

Investment for new machinery with a three-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

	Project Y	Project Z
Sales……..	$350,000	$280,000
Expenses
Direct materials	49,000	35,000
Direct labor	70,000	42,000
Overhead including depreciation	126,000	126,000
Selling and administrative expenses	25,000	25,000
Total expenses	270,000	228,000
Pretax Income	80,000	52,000
Income taxes (10%)	24,000	85,000
Net income	$56,000	$36,000

Required

1. Compute each project’s annual expected net cash flows,(Round the net cash flows to the nearest dollar.)

2. Determine each project’s payback period. (Round the payback period to two decimals.)

3. Compute each project’s accounting rate of return.(Round the percentage return to one decimal.)

4. Determine each project’s net present value using 8% as the discount rate. For part 4 only, assume that cash flows occur at each year-end. (Round the net present value to the nearest dollar.)

Analysis Component

5. Identity the project you would recommend to management and explain your choice.

To determine

Concept introduction:

Cash flow-it generally defines the advantages and the cost of a future project. As cost is represented through cash outflows and benefits as cash inflow. The present value of a cash flow refers to the discounted value of the present month of prospect sum of money.

Requirement 1:

Computation of each project annual expected net cash flows.

Answer to Problem 2PSA

Cash flow after tax

143500

153066.66

Explanation of Solution

Part A

Particulars	Detail	Project Y	Project Z
Sales	A	350000	280000
Expenses
Direct material		49000	35000
Direct labor		70000	42000
Overhead including depreciation		126000	126000
Selling and administrative		25000	25000
Total expenses	B	270000	228000
Income before tax	C=A-B	80000	52000
Income tax-30%	D=0.3*C	24000	15600
Profit after tax	E=C-D	56000	36400
Depreciation	F	87500	116666.66
Cash flow after tax	G=E+F	143500	153066.66

To determine

Concept introduction:

Payback period-it helps to indicate the time taken by the investment to realise its cost. It does not take into account the profitability of the investment and the time value of money.

Requirement 2:

To explain:

Each project’s payback period.

Answer to Problem 2PSA

Payback period

2.44

1.83

Explanation of Solution

Calculation of pay back period

Payback period = $\frac{\cos tofinvestment}{annualcashflow}$

Particulars	Detail	Project Y	Project Z
Cost of investment	A	350000	280000
Annual cash flows	B	143500	153066.66
Payback period	C=A/B	2.44	1.83

To determine

Concept introduction:

Accounting rate of return is the relationship between standard accounting profits after tax and outlay in the project. It is that ratio which takes into consideration earnings from a project in relative to the investment made in the project. It is determined in percentage.

Requirement 3:

Computation of accounting rate of return.

Answer to Problem 2PSA

Accounting rate of return

32%

26%

Explanation of Solution

There are different views in regards to compute accounting rate of return( ARR).

Method 1-

Accounting rate of return = $\frac{averageprofitaftertax}{initialinvestment}$

Method 2-

Accounting rate of return = $\frac{averageprofitaftertax}{averageinvestment}$

If a company uses a straight line of depreciation method, it can be found the average amount of investment out by using,

Annual average investment = $$ $\frac{beginingbookvalue+endingbookvalue}{2}$

Particulars	Details	Project Y	Project Z
Starting investment	A	350000	280000
Ending investment	B	0	0
Average investment	C=A+B/2	175000	140000
Particulars	Details	Project Y	Project Z
Average profit after tax	A	56000	36400
Average investment	B	175000	140000
Accounting rate of return	C=A/B	32%	26%

To determine

Concept introduction:

Net present value-it is calculated by discounting future cash flows. It is calculated at the required rate of return of project and afterwards subtracted by cash invested. If project has positive net present value(NPV) it is accepted.

Requirement 4:

Each project’s net present value (NPV) using 8% as the discount rate, assuming cash flow occur at each year end.

Answer to Problem 2PSA

Net present value(NPV) at 8% discounting rate

125290.20

114467.63

Explanation of Solution

Particulars	Details	Project Y	Project Z
Annual net cash flows	A	143500	153066.66
The present value at the rate of 8% for cumulative 4 and 3 years	B	3.31	2.58
The present value of cash flows	C=A*B	475290.20	394467.63
Cost of investment	D	350000	280000
Net present value(NPV)	C-D	125290.20	114467.63

To determine

Concept introduction:

Net present value-it is calculated by discounting future cash flows. It is calculated at the required rate of return of the project and afterward subtracted by cash invested. If the project has a positive net present value(NPV) it is accepted.

Requirement 4:

Identifying the project to be recommended to the management.

Answer to Problem 2PSA

Project Y would be more viable to the company as it has a higher net present value than project Z i.e.$125290.20 and $114467.63

Explanation of Solution

Project Y would be more viable to the company as it has higher net present value than project Z i.e.$125290.20 and $114467.63,apart from that it has higher accounting rate of return than Z i.e. it has 32% rate in comparison to Z i.e. 26%.Though it has longer payback period than project Z then also it is recommended to select project Y, as for selecting any project most appropriate method is to find out project’s net present value(NPV) and the net present value of project Y is positive and higher than Project Z.